Market Structure

Options are purchased and traded either on an organized exchange (such as the United Currency Options Market of the PHLX) or in the over-the-counter (OTC) market. Exchange-traded options or listed options are standardized contracts with predetermined exercise prices, and standard expiration months (March, June, September, and December plus two near-term months). UCOM options are available in six currencies—the Australian dollar, British pound, Canadian dollar, euro, Japanese yen, and Swiss franc—and are traded in standard contracts half the size of the CME futures contracts. The euro contracts have replaced contracts in the Deutsche mark and French franc. Contract specifications are shown in Exhibit 8.4. The PHLX trades only European-style standardized currency options. Its margin requirements change over time.

The PHLX also offers customized currency options, which allow users to customize various aspects of a currency option, including choice of exercise price, expiration date (up to two years out), and premium quotation as either units of currency or percentage of underlying value. Customized currency options can be traded on any combination of the six currencies for which standardized options are available, along with the Mexican peso and the U.S. dollar.2 The contract size is the same as that for standardized contracts in the underlying currency. Other organized options exchanges are located in Amsterdam (European Options Exchange), Chicago (Chicago Mercantile Exchange), and Montreal (Montreal Stock Exchange).

Exhibit 8.4 Contract Specifications for PHLX Standardized Currency Options Contracts

*Even strike prices (i.e., 100, 102)

**Odd strike prices (i.e., 99, 101)

Source: Data collected from PHLX’s Web site at www.phlx.com.

Over-the-counter (OTC) options are contracts whose specifications are generally negotiated as to the amount, exercise price and rights, underlying instrument, and expiration. OTC currency options are traded by commercial and investment banks in virtually all financial centers. OTC activity is concentrated in London and New York, and it centers on the major currencies, most often involving U.S. dollars against pounds sterling, euros, Swiss francs, Japanese yen, and Canadian dollars. Branches of foreign banks in the major financial centers are generally willing to write options against the currency of their home country. For example, Australian banks in London write options on the Australian dollar. Generally, OTC options are traded in round lots, commonly $5 million to $10 million in New York and $2 million to $3 million in London. The average maturity of OTC options ranges from two to six months, and very few options are written for more than one year. American options are most common, but European options are popular in Switzerland and Germany because of familiarity.

The OTC options market consists of two sectors: (1) a retail market composed of nonbank customers who purchase from banks what amounts to customized insurance against adverse exchange rate movements and (2) a wholesale market among commercial banks, investment banks, and specialized trading firms; this market may include interbank OTC trading or trading on the organized exchanges. The interbank market in currency options is analogous to the interbank markets in spot and forward exchange. Banks use the wholesale market to hedge, or “reinsure,” the risks undertaken in trading with customers and to take speculative positions in options.

Most retail customers for OTC options are either corporations active in international trade or financial institutions with multicurrency asset portfolios. These customers could purchase foreign exchange puts or calls on organized exchanges, but they generally turn to the banks for options in order to find precisely the terms that match their needs. Contracts are generally tailored with regard to amount, strike price, expiration date, and currency.

The existence of OTC currency options predates exchange-traded options by many years, but trading in OTC options grew rapidly at the same time that PHLX trading began. The acceleration in the growth of options trading in both markets appears to spring from the desire by companies to manage foreign currency risks more effectively and, in particular, from an increased willingness to pay a fee to transfer such risks to another party. Most commentators suggest that corporate demand has increased because the greater volatility of exchange rates has increasingly exposed firms to risks from developments that are difficult to predict and beyond their control.

The growth of listed options, especially for “wholesale” purposes, apparently is putting pressure on the OTC markets for greater standardization in interbank trading. In some instances, OTC foreign currency options are traded for expiration on the third Wednesday of March, June, September, and December, to coincide with expiration dates on the U.S. exchanges.

Although the buyer of an option can lose only the premium paid for the option, the seller’s risk of loss is potentially unlimited. Because of this asymmetry between income and risk, few retail customers are willing to write options. For this reason, the market structure is distinctly asymmetrical when compared with the ordinary market for spot and forward foreign exchange, where there is a balance between customers who are purchasing or selling currency and the interbank market likewise has a reasonable balance.

1 Bradford Cornell and Marc Reinganum, “Forward and Futures Prices: Evidence from the Foreign Exchange Markets,” Journal of Finance, December 1981, pp. 1035-1045.

2 The Australian dollar may be matched only against the U.S. dollar.

Using Currency Options

To see how currency options might be used, consider a U.S. importer with a €62,500 payment to make to a German exporter in 60 days. The importer could purchase a European call option to have the euros delivered to him at a specified exchange rate (the strike price) on the due date. Suppose the option premium is $0.02 per euro and the exercise price is $1.44. The importer has paid $1,250 for a €144 call option, which gives it the right to buy €62,500 at a price of $1.44 per euro at the end of 60 days. If at the time the importer’s payment falls due, the value of the euro has risen to, say, $1.50, the option would be in-the-money. In this case, the importer exercises its call option and purchases euros for $1.44. The importer would earn a profit of $3,750 (62,500 × 0.06), which would more than cover the $1,250 cost of the option. If the rate has declined below the contracted rate to, say, $1.41, the € 144 option would be out-of-the-money. Consequently, the importer would let the option expire and purchase the euros in the spot market. Despite losing the $1,250 option premium, the importer would still be $625 better off than if it had locked in a rate of $1.44 with a forward or futures contract.

Exhibit 8.5 illustrates the importer’s gains or losses on the call option. At a spot rate on expiration of $1.44 or lower, the option will not be exercised, resulting in a loss of the $1,250 option premium. Between $1.44 and $1.46, the option will be exercised, but the gain is insufficient to cover the premium. The break-even price—at which the gain on the option just equals the option premium—is $1.46. Above $1.46 per euro, the option is sufficiently deep in-the-money to cover the option premium and yield a—potentially unlimited—net profit.

Because this is a zero-sum game, the profit from selling a call, shown in Exhibit 8.6, is the mirror image of the profit from buying the call. For example, if the spot rate at expiration is above $1.46/€, the call option writer is exposed to potentially unlimited losses. Why would an option writer accept such risks? For one thing, the option writer may already be long euros, effectively hedging much of the risk. Alternatively, the writer might be willing to take a risk in the hope of profiting from the option premium because of a belief that the euro will depreciate over the life of the contract. If the spot rate at expiration is $1.44 or less, the option ends out-of-the-money and the call option writer gets to keep the full $1,250 premium. For spot rates between $1.44 and $1.46, the option writer still earns a profit, albeit a diminishing one.

In contrast to the call option, a put option at the same terms (exercise price of $1.44 and put premium of $0.02 per euro) would be in-the-money at a spot price of $1.41 and out-of-the-money at $1.50. Exhibit 8.7 illustrates the profits available on this euro put option. If the spot price falls to, say, $1.38, the holder of a put option will deliver €62,500 worth $86,250 (1.38 × 62,500) and receive $90,000 (1.44 × 62,500). The option holder’s profit, net of the $1,250 option premium, is $2,500. As the spot price falls further, the value of the put option rises. At the extreme, if the spot rate falls to zero, the buyer’s profit on the contract will reach $88,750 (1.44 × 62,500 − 1,250). Below a spot rate of $1.42, the gain on the put option will more than cover the $1,250 option premium. Between $1.42—the break-even price for the put option—and $1.44, the holder would exercise the option, but the gain would be less than the option premium. At spot prices above $1.44, the holder would not exercise the option and so would lose the $1,250 premium. Both the put and the call options will be at-the-money if the spot rate in 60 days is $1.44, and the call or put option buyer will lose the $1,250 option premium.

Exhibit 8.5 Profit from Buying a Call Option for Various Spot Prices at Expiration

As in the case of the call option, the writer of the put option will have a payoff profile that is the mirror image of that for the buyer. As shown in Exhibit 8.8, if the spot rate at expiration is $1.44 or higher, the option writer gets to keep the full $1,250 premium. As the spot rate falls below $1.44, the option writer earns a decreasing profit down to $1.42. For spot rates below $1.42/€, the option writer is exposed to increasing losses, up to a maximum potential loss of $88,750. The writer of the put option will accept these risks in the hope of profiting from the put premium. These risks may be minimal if the put option writer is already short euro.

Exhibit 8.6 Profit from Selling a Call Option for Various Spot Prices at Expiration

Typical users of currency options might be financial firms holding large investments overseas where sizable unrealized gains have occurred because of exchange rate changes and where these gains are thought likely to be partially or fully reversed. Limited use of currency options has also been made by firms that have a foreign currency inflow or outflow that is possibly but not definitely forthcoming. In such cases, when future foreign currency cash flows are contingent on an event such as acceptance of a bid, long call or put positions can be safer hedges than either futures or forwards.

Application Speculating with a Japanese Yen Call Option 

In March, a speculator who is gambling that the yen will appreciate against the dollar pays $680 to buy a yen June 81 call option. This option gives the speculator the right to buy ¥6,250,000 in June at an exchange rate of ¥1 = $0.0081 (the 81 in the contract description is expressed in hundredths of a cent). By the expiration date in June, the yen spot price has risen to $0.0083. What is the investors net return on the contract?

Solution. Because the call option is in-the-money by 0.02 cents, the investor will realize a gain of $1,250 ($0.0002 × 6,250,000) on the option contract. This amount less the $680 paid for the option produces a gain on the contract of $570.

Exhibit 8.7 Profit from Buying a Put Option for Various Spot Prices at Expiration

For example, assume that a U.S. investor makes a firm bid in pounds sterling to buy a piece of real estate in London. If the firm wishes to hedge the dollar cost of the bid, it can buy pounds forward so that if the pound sterling appreciates, the gain on the forward contract will offset the increased dollar cost of the prospective investment. But if the bid is eventually rejected, and if the pound has fallen in the interim, losses from the forward position will have no offset. If no forward cover is taken and the pound appreciates, the real estate will cost more than expected.

Currency call options can provide a better hedge in such a case. Purchased-pound call options would provide protection against a rising pound; and yet, if the bid were rejected and the pound had fallen, the uncovered hedge loss would be limited to the premium paid for the calls. Note that a U.S. company in the opposite position, such as one bidding to supply goods or services priced in pounds to a British project, whose receipt of future pound cash inflows is contingent on acceptance of its bid, would use a long pound put position to provide the safest hedge.

Exhibit 8.8 Profit from Selling a Put Option for Various Spot Prices at Expiration

Currency options also can be used by pure speculators, those without an underlying foreign currency transaction to protect against. The presence of speculators in the options markets adds to the breadth and depth of these markets, thereby making them more liquid and lowering transactions costs and risk.

Currency Spread.

A currency spread allows speculators to bet on the direction of a currency but at a lower cost than buying a put or a call option alone. It involves buying an option at one strike price and selling a similar option at a different strike price. The currency spread limits the holder’s downside risk on the currency bet but at the cost of limiting the positions upside potential. As shown in Exhibit 8.9a, a spread designed to bet on a currency’s appreciation—also called a bull spread—would involve buying a call at one strike price and selling another call at a higher strike price. The net premium paid for this position is positive because the former call will be higher priced than the latter (with a lower strike, the option is less out-of-the-money), but it will be less than the cost of buying the former option alone. At the same time, the upside is limited by the strike price of the latter option. Exhibit 8.9b shows the payoff profile of a currency spread designed to bet on a currency’s decline. This spread—also called a bear spread—involves buying a put at one strike price and selling another put at a lower strike price.